Depreciation of currency : A Boon in disguise or An Evil ?

Before talking about depreciation of currency it is important to point out that there are two kinds of exchange rates that exist: A fixed exchange rate and a flexible Exchange Rate. For example: China follows a fixed exchange rate system while India follows a flexible exchange rate system. What is the main difference between the two systems one might ask?

The main difference in the two systems is that in case of fixed exchange rate system (as the name suggests) the exchange rate of the currency is fixed and can be changed only by the government and not by the market forces. A government if it wishes then can either revalue or devalue its currency. But in the case of flexible exchange rate system the value of the currency is determined externally via the market forces i.e. by the demand and the supply of the currency in the market. Now it is here the concept of depreciation comes in.

A currency is said to depreciate when its value declines or falls against another currency i.e. when more of domestic currency is required to buy one unit of another foreign currency then the domestic currency is said to have depreciated against that foreign currency.  For example: If the exchange rate of INR against USD yesterday hypothetically was 46.40/ 47.20 and today is 48.50/ 49.30 then the INR is said to have depreciated against the US dollars. Exact opposite to depreciation is the concept of appreciation where lesser units of domestic currencies are required to buy one unit of foreign currency.  It is to be remembered always that it is not in the hand of a government to control the currency as such. Though there are ways to do so but for now let’s assume that it is only the market forces that decides when a currency should appreciate or depreciate. It is important to talk about depreciation or appreciation of a currency due to its implications.

The following implications that I am going to talk about is not immediate i.e. it is not that all this would happen on the same day when the currency depreciates. The implications are due to persistent fall of the currency over a period of time. Now let’s see what happens:

INR depreciates against USD à For people in US it is cheaper to buy INR goods à  India’s export becomes competitive à Exports to US risesà Imports from US falls as it is expensive to buy goods from there àTrade Account improves à Net Exports rises àY (output) rises as Y = C + I + G + NX à increase in GDP

When the currency is cheap and interest rates are highà Investors willing to investà more FII’s and FDI’s à capital inflow à money supply increaseà LM curve shifts to the rightà output increases

Before I continue I will like to point out one reason why the currency might depreciate. But the big question is if this is the case that the external market forces are the reason for a currency to depreciate then that will mean that there is no control and the economy should continue to grow infinitely. But this is not the case as there exists automatic stabilizers in the economy. To explain this I would need to take help of the IS-BP-LM model or the Mundell-Fleming model for currency exchange in a floating exchange rate system. Let’s see how: (Of course as always there are lots of assumptions that I am making to simplify the model for understanding)

Let us say that initially we are at E1 with interest rate at i^w and output at Y1. Now the government has introduced a new expansionary monetary policy for which the LM curve has shifted to the right from LM to LM1à equilibrium shifts to E*à interest rates fall to i*à there is huge capital outflow as investors see lower returns à this leads to lower demand for INR as the investors sell INR and convert currency to USDà lower demand for INR in the currency market leads INR to depreciate. This withdrawal of money from the economy also to certain extent helps to curb inflation. 

MUNDELL – FLEMING MODEL

                            FALL IN DEMAND FOR INR (leading to depreciation)

This is one way how a currency may depreciate.

Now as seen above, the converse is also true as the currency starts to depreciateà exports become more competitiveà exports rises and imports fall à there is a change in NXà in case of IS curve the NX lies in the autonomous component of the equationà Y = m(A0 – br) where m = multiplier and A0 the autonomous componentà As the A0 increases it causes in Y which is larger due the presence of the multiplierà this is what is causing a larger increase in Y in the figure (Mundell- Fleming Model)àIS curve shifts thus from IS to IS1à equilibrium shifts from E* to E2 à Y increases from Y1 to Y2à increase in output and thus GDP.

The automatic stabilization that I was talking about before has been achieved through the rightward shift of the IS curve. The interest rates have been restored to the original level along with which the output has increased.

Therefore it may seem like that the ultimate benefits achieved from depreciation of a currency are larger for the economy as there is a rise in the output and lowering of inflation as well. So through depreciation two birds can been killed with one stone. But there is a big catch:

As we all remember: Money Supply = money multiplier * High Powered money i.e. Ms = mm * H

But this H has two components: one is domestic (Hd) and one is foreign (Hf) i.e. Ms= mm * (Hf + Hd)

The central bank can control the Hd component of the high powered money as it is domestic but the Hf component is not in their control and is determined primarily by the market forces. So, if the Hf component goes into a spiral then it would really hard for the central bank to control the money supply in the economy. A frequent fluctuation of the money supply in the economy can be disastrous as it may lead to hyperinflation. As the currency continues to depreciate for longer period of time the value of the domestic currency will fall which spells gloom for the economy. On the other hand as the currency persistently depreciates it will be much expensive for the country to import goods like crude oil which is primarily traded in USD. This would lead cost push inflation in the economy. It might happen that as inflation level raises unemployment level also starts rising. Thus the economy would fall into a stagflation scenario. Thus a country has to decide whether it is worth it to let the currency depreciate for a long period of time and enjoy short term benefits at the cost of long term doom.  This is exactly why no country wishes to face this problem and does not deliberately depreciate their currency.